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External Benchmark-Linked Interest Rates Could Be A Welcome Change For Borrowers

In a move to improve transparency in floating loan interest rates and to ensure better transmission of rate cuts to the common man, the RBI has asked lenders to link all floating-rate loans to external benchmarks starting April 1. The external benchmarks shall be one of the following.

Reserve Bank of India Repo Rate

Government of India 91 days Treasury Bill yield produced by the Financial Benchmarks India Private Ltd (FBIL)

Government of India 182 days Treasury Bill yield produced by the FBIL

Any other benchmark market interest rate produced by FBIL

This is going to replace the internal benchmarks such as Prime Lending Rate (PLR), Benchmark Prime Lending Rate (BPLR), Base rate and Marginal Cost of Funds based Lending Rate (MCLR), that floating loans are connected to at present.

Existing loans will stay unaffected

The new rule will apply to all retail and small business loans with floating interest rate from April 1. Existing loans will not be affected. Going forward banks are free to decide on the external benchmark and fix the spread at the beginning of the loan cycle. What is a spread? Your loan rate consists of the base rate (in this case, the benchmark) plus the spread which is calculated by factoring in such requirements as the lender’s profit margins, the borrower’s credit score, loan size, etc. Now, the spread will remain fixed through the tenure of the loan unless the borrower’s credit score changes substantially.

A welcome change

This new loan pricing mechanism will come in to play three years after the Marginal Cost of Funds based Lending Rate (MCLR) was introduced. The MCLR rate was a replacement of its predecessor the benchmark prime lending rate (BPLR) which would consider the average cost of fund deposits in a bank rather than the marginal cost, while calculating the lending rate.

The MCLR rate considered the cost the lenders pay on every additional deposit received. However, this mechanism had a problem per se – banks continued to link the old loans with base rate while only the new loans were linked under MCLR. Later the RBI made it mandatory for banks to link the base rate with MCLR, but the gap between the loan rates and policy rate persisted more often than not.

A common grievance was that banks would be quick to change the loan rates when the RBI raised the policy rate but the loan takers were not passed on the benefits promptly and proportionately when the rates dipped. Now, with the new rule, the policy rates are expected to be transmitted more transparently to the borrowers. This, of course, is great news for the common man whose EMIs would be in sync with market realities.